Sense on Cents

The broad equity market indices are down 3+% on the day. Why would that happen when the bulk of company news today was generally positive?  At least on the surface the news was positive:

1. Bank of America posted .44 earnings per share vs. expectations of .04
2. Eli Lilly earnings were up 23% outpacing expectations.
3. Halliburton disappointed with earnings down 35% but that is due to the massive correction in the price of oil from a year ago.
Merger Activity:
4. Oracle is purchasing Sun Microsystems in a $7.4 billion deal.
5. Pepsi is buying two bottling companies for $6 billion.
6. Glaxo is purchasing Stiefel for $2.9 billion.

Leading economic indicators declined by .3 but that decline is offset by an improved reading from the prior month.

Then, why is the market down so much? Two reasons are promoted, but only one of them is getting proper coverage.

Market analysts supposedly are focused today on the ongoing increases in chargeoffs and writedowns on the loan portfolios in the banking industry. These loans consist of credit card loans, residential mortgages, commercial mortgages, and corporate loans.

I don’t buy this line of reasoning for today’s selloff. Increased chargeoffs and writedowns have been widely expected for a while. The level of reserves taken by the banks has been widely panned as being insufficient. Then why is the market down so much?

In my opinion, the reason for the market selloff is an underlying concern that Uncle Sam is going to execute a massive equity swap in the banks. What does that mean? Remember, a tremendous amount of government funding that has been injected into the banking system has been in the form of preferred shares in which the taxpayers earn a rate of interest. These preferred shares are senior to common equity (stock) if the bank were to enter bankruptcy. Uncle Sam was protecting the taxpayers’ interest by making sure the money was injected in the form of the preferred and not in the form of common equity.

If the preferred stock is swapped for common stock, Uncle Sam would be taking significantly greater risk on behalf of the taxpayers and the banks would be forced to issue more shares. The increased issuance of shares would dilute the interests of current shareholders. That dilution lowers the value of the current stock and the price of that stock goes DOWN.

Today, most banks are down at least 10% and the major banks are down close to 20%.

While the administration may attempt to utilize this equity swap as a means of increasing the equity capital in the banking system, the taxpayers are taking more risk in the process. Why isn’t this process or proposal debated in Congress so the public is fully aware of the risks involved and can voice their opinions? With Uncle Sam taking a greater equity stake in the banks, the operation of the banks will be under greater scrutiny and compensation levels will be even more closely monitored. Banks lose, taxpayers lose, government control wins.

LD

Representative Darrell Issa (R-CA) just spoke on Bloomberg that banks will likely redirect TARP funds within the banking system (please see my piece earlier today on that very topic). Additionally, he pointed blame at those in Congress and the Fed for promoting unwise and unhealthy lending. He specifically named Barney Frank.

This entry was posted on Monday, April 20th, 2009 at 2:30 PM and is filed under Bank Failure, Bank of America, Bank Stress Test, Wall Street. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.